Draft: Retail Structured Products Principles from RSP Taskforce - March 6, 2008

Structured Products: Principles for Managing the Distributor-Individual Investor Relationship

DRAFT - as of March 6, 2008

The distributor-individual investor relationship should deliver fair treatment of the individual investor. Individual investors need to take responsibility for their investment goals and to stay informed about the risks and rewards of their investments. Distributors can play a key role in helping them achieve these objectives.

In light of the increased interest in structured products as part of individual investors’ investment and asset allocation strategies, it is important for firms to keep these principles in mind in their dealings with individual investors in structured products. These principles complement our recently released, “Retail Structured Products: Principles for Managing the Provider-Distributor Relationship,” available at the websites of the five sponsoring associations, which focus on the relationship between manufacturers and distributors. These principles apply to the relationship between the distributor and the individual investor.

Although these principles are aspirational in nature and do not create enforceable obligations or duties, firms involved in the distribution of structured products to individual investors are encouraged to reflect these principles in their policies and procedures. Further, each firm is encouraged, given differing regulatory environments and both cultural and client base differences, to consider the extent to which the firm should adapt these principles to its particular circumstances.

While some or most of these principles may be applicable to all individual investors, their primary focus is on those individual investors, often referred to as “retail” investors, rather than high net worth clients or accredited investors.

Overview

The term "structured products" refers to a variety of financial instruments that combine various cash assets and/or derivatives to provide a particular risk/reward profile that may not otherwise be available in a traditional investment. The return of a structured product is usually derived from the performance of one or more underlying assets. Examples of underlying assets include, but are not limited to; interest rates, a particular equity or debt instrument, a basket of securities, a securities index or indices, an individual commodity or commodities, a commodities index, an individual currency or currency basket or any combination thereof.

Some structured products offer full or partial principal protection, while others have no principal protection. Some offer a yield; others do not. It is possible that the value of an individual structured product may not increase as much as the underlying asset, or may decrease more than the underlying asset. Some structured products offer individual investors access to new asset classes that can help with portfolio diversification.

Structured products can be more or less risky than traditional products such as equities, fixed income products, or mutual funds. Where products are highly structured, it may be difficult for an individual investor to understand the mechanics of the product, although there is no necessary link between product complexity and investment risk - complex products may be low risk, and vice versa. It is important that an investor understands the role in an investment strategy that can be played by any particular structured product in light of the investor’s specific investment objectives, risk tolerance, and investment horizons.


Principles

1. Product Transparency

All public materials containing product descriptions of structured products should be clear and not misleading, and should contain adequate disclosure of the nature of the product and of its benefits, risks, and limitations. The disclosure should, to the extent permitted by applicable law and regulation, be drafted in a way that takes into account the knowledge and sophistication of the clients in the target market.

Where a distributor is primarily responsible for the creation of marketing materials,[1] or is responsible for a prospectus, the distributor should use reasonable efforts to ensure that the material features of structured products are clearly articulated and delineated to individual investors in a way that enables them to evaluate the investment from a risk/reward perspective. This will be helpful to both individual investors’ and financial advisors’[2] understanding of the product. Further, to the extent that a distributor is primarily responsible for the creation of marketing materials, such materials should be adapted to, and reflective of, the proposed target audience. For example, it should be clearly disclosed when returns on a structured product are linked to an underlying asset.

Marketing materials that are geared to individual investors should be subject to review by the distributor’s appropriate supervisory staff, as well as other internal processes, such as compliance or legal, as appropriate.

2. Risk Disclosure

Risk disclosure is important to an investor’s understanding of structured products and should be made available to investors before a decision to invest is made. Investors should understand the risks inherent in the product before investing in it. Investors should be informed of the types of risks generally associated with products of the type concerned, and, subject to individual regulatory standards as to specific language required, particular prominence should be given to any risk not usually associated with a product of that particular type, including risks arising from the underlying asset, liquidity and market risks in relation to the product itself, creditworthiness of the issuer, tax considerations, risk of loss due to sale of the product before maturity, and any other material risks associated with the structure of the product. Where information on past performance is given, the presentation should be fair and not misleading, and, in particular, should acknowledge any limitations in available data.

3. Fees and Costs

Investors in a structured product should be informed of the existence of fees, costs, commissions, discounts, and any other sums paid to the distributor for acting as such over the life of that product. Distributors should have internal processes and controls in place to consider the appropriateness of fees and other incentives given local market conditions and regulatory requirements. A distributor's internal processes and controls should also consider the level of disclosure regarding such fees and costs in light of their possible impact on the secondary market value of the structured product concerned.

Potential Conflicts Management

Distributors should have internal processes and controls in place to consider potential conflicts issues and identify measures designed to mitigate, manage, or disclose material conflicts of interest arising from the sale of structured products. Such processes should, where necessary or appropriate, provide timely, adequate, and clear disclosure related to conflicts of interest or potential conflicts of interest that may exist or arise in connection with the sale of the structured product, or as a result of the business they conduct.

5. Credit Ratings

Distributors should use credit ratings responsibly. Credit ratings of issuers, while important, may not represent a rating of the potential performance of the individual structured product itself. If credit ratings are provided, the related disclosure should make clear the significance of the rating.


6. New Product Review

Distributors should understand the products they distribute. New structured products, whether developed by the distributor or developed by a third-party provider or manufacturer, should be subject to the distributor’s product review and assessment process. This process should take into account the nature of the new structured product, the target market, and an assessment as to whether the product is appropriate for that target market. Distributors should also have a process for determining what generally constitutes a “new product.” It is not sufficient for a distributor to accept a third-party manufacturer’s assessment regarding appropriateness of structured products for individual investors. Distributing firms should conduct an independent assessment.


7. Liquidity/Secondary Market

Investors should be informed before investing of the likelihood of their being able to sell or otherwise realize the value of a particular structured product prior to maturity, and of the ways in which this might be done. Any secondary market facilities to be provided by the distributor itself or through an exchange should be disclosed. If there is little likelihood of such sale or other liquidation being possible, that fact should be clearly disclosed. Investors should be made aware that sales in the secondary markets, even where possible, may be at prices that are below either the redemption value at maturity or the new issue price. In addition, distributors should make a clear distinction between the likely value of the structured product and the value of the underlying asset, noting in particular that these two values may not necessarily move in tandem.

Structured products should be valued on a regular basis and disclosed to the investor through the distributor’s normal client statement process or otherwise.


8. Client Appropriateness

Where a firm actively markets a particular product, as opposed to merely executing transactions on clients’ instructions, it should determine which particular types of clients the product could properly be sold to (appropriateness) and may also be required to determine whether the particular product is right for a particular client (suitability). Methodologies and standards for making these determinations should be developed by the distributor and adequately communicated to the distributor’s financial advisors. Liquid net worth, degree of sophistication, age, and investment experience are several variables that may be relevant to such an assessment. Also, distributors should consider how a specific structured product would fit into an individual’s portfolio. These standards should be reviewed periodically and amended, as needed.


9. Financial Advisor Training

Structured products vary a great deal as to their terms, risk/reward profile, liquidity/availability of a secondary market, underlying asset, underlying value, and a variety of other factors. As such, it is important that financial advisors interacting with individual investors have an adequate understanding of structured products in general as well as an understanding of the characteristics of the individual structured products being offered. The financial advisor should be able to clearly explain the product’s features to an individual investor. Distributors should provide their financial advisors with the necessary training, or access to training, in structured products, including both the benefits and risks of the products, and should consider providing educational materials on structured products generally.


10. Oversight and Compliance

Structured product sales to individual investors should be subject to the distributor’s internal compliance and review processes. Distributors should have supervisory procedures in place covering transactions in structured products, which should involve supervisory staff of appropriate seniority in light of the nature of the particular product and investor target market. Supervisory responsibilities may encompass sales practices, reasonableness of profit/loss potential, fees, and adequacy of training. Managers performing such supervision should have access to appropriate legal and compliance department support.




Tax Implications

Investments in structured products may have tax consequences for individual investors depending on their personal circumstances and jurisdiction of residence. Investors should be encouraged to discuss the specific tax implications of structured products with their accountant, tax attorney, or other tax professional.


Post-Trade Follow-up/Product Life Cycle Issues

Distributors should provide financial advisors with the necessary information to help clients monitor performance of any structured product in which they have invested, and access to information regarding the terms of that structured product, including its maturity, pay-out details, and other pertinent information.


Endnotes:

[1] Manufacturers have a similar responsibility, which is addressed in “Retail Structured Products: Principles for Managing the Provider-Distributor Relationship,” Point #5, Joint Trade Associations, July 2007.

[2] “Financial advisor” refers to the firm’s employees, or independent contractors, who interact directly with individual investors and who are registered to solicit trades and effect transactions. The formal term may vary significantly by firm and/or jurisdiction.